On Wednesday, September 21st, we learned of the Federal Reserve’s decision to increase the federal funds rate—its monetary policy rate—by 75 basis points, leaving it within the range of 3% to 3.25% (see Figure 1). Prior to the announcement, the Fed had already raised its policy rate four times this year. In its June and July meetings, it increased the rate by 75 basis points, magnitudes not seen since 1994. In our opinion, it would not be surprising if we end December with the rate in the range of 4.25% to 4.5%.
The reason behind these increases is one, and one only: inflation, especially core inflation, which rose 0.6% in August, reaching 6.3% year-on-year (0.4 points higher than the figure for July, as seen in Figure 2). In fact, before the Fed's announcement, the one-year Treasury bond rate had exceeded 4% and the two-year bond was remarkably close, levels not seen since 2007. This is good for those who want to invest in fixed income. Market expectations of higher inflation were also reflected in the rates of Treasury Inflation-Protected Securities (TIPS): the five-year and the ten-year were in the range of 1.2% to 1.3%. On the other hand, for those who invest in stocks, these higher rates will force them to position their portfolios more carefully.
The Federal Reserve is not the only central bank dealing with a high-inflation problem. In Europe, Sweden announced a 100-basis-point hike in its policy rate on Tuesday 9/20, its biggest increase since 1992, taking it to 1.75%. The inflation target there is 2% per year, but in August the annual inflation reached 9%. On Thursday, the central banks of England and Norway raised their rates by 50 basis points, while Switzerland’s settled on 75 points.
In our opinion, the Eurozone and Japan is where the most pressure will be felt after the Fed’s rate hike. In Japan, the country's central bank has refused to let interest rates rise, pushing the local currency, the yen, to a 24-year low. Given this, the Japanese government announced its first foreign-exchange intervention since 1998. In our view, that country's strategy is not sustainable: eventually the Bank of Japan will have to yield and make the corresponding monetary adjustment.
In the eurozone, the European Central Bank (ECB) has been slow to raise rates, which has hit the euro and, consequently, increased inflation. The main problem with higher rates is the elevated level of public debt of countries such as Italy and Spain, which exposes them to the risk of default if the interest they must pay skyrockets.
In the case of Chile, the Central Bank began to raise its guiding rate more than a year ago, preempting more developed countries. This leaves it in a more comfortable position than the ECB. The dollar had traded at around 940 pesos before the Fed's announcement, and it is very likely that the low value that the peso has reached was one of the reasons that led the Central Bank to further raise its Monetary Policy Rate by one percentage point this month, leaving it at 10.75%.
The peso could continue to drop as the market factors in the greater likelihood of higher rates in the United States, that last more, and are delivered over a longer stretch of time. In any case, Chile’s Central Bank’s currency-market intervention (in place since July) lasts until September 30th, and the Bank continues to have instruments to control excessive volatility in the local currency.
To conclude, higher rates in the US will force most other central banks to raise their own interest rates. This will make access to credit more expensive and may cause severe contractions in some countries, which will translate into lower economic output and unemployment. Each central bank will have to gauge the use of its instruments appropriately to avoid very sharp fluctuations, taking into account additional factors such as the current-account balance, and the level of foreign-denominated debt. The bright side will be controlling inflation, which in much of the world has been above its normal levels for too long. Avoiding an adjustment that may be painful today will probably only lead to even more painful adjustments in the future.
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